We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
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Tuesday, December 23, 2008

Mark-to-market accounting has got to be one of the most controversial topics of the year. Unfortunately, its also rife with bias and downright zealotry. You have on one side apologists for financial companies and/or people looking for a one-trick excuse for the whole financial meltdown. On the other hand, you have people who believe all of Wall Street is just lying and everything they own is worthless.

But somewhere in there is a legitimate, rational debate.

First let's consider what accounting is supposed to achieve. Broadly speaking, accounting should have a few simple goals:

1) Accurately reflect the current economic situation of a firm.

2) Allow for comparison of a firm's results and position over time.

3) Allow for comparison of one firm to another.

4) Be as objective as possible.

Now let's consider how mark-to-market as a concept fits in with these goals. I call mark-to-market a "Liquidation Theory of Accounting." In other words, by marking all assets to where they could be sold, one is valuing a firm based on what it might be worth in liquidation.

This is clearly appropriate with any pool of assets intended to be traded in the open market. But in other assets, it isn't obvious that mark-to-market serves the 4 basic goals above. Take a life insurance company which bought the longest available Treasury Strip (5/15/2038) on August 8, when it was first trading. The position is an offset to their long-term liabilities, say the life insurance policy of a young person. For the sake of argument (and brevity) let's assume that the actuarial life of the policy holder is exactly 30-years, and the accrued interest on the strip will exactly cover the life policy with a small profit.

The strip was trading at $25.6 on 8/8, but is now about $42.5, an handsome 66% return.

But has the life company's economic situation changed? Is that firm 66% better off? We'd all agree that no, it isn't. The basic economics of the firm haven't changed at all. They have the same liabilities and same cash flow stream. If we followed strict mark-to-market theory, we'd mark both the asset and the liability higher, leaving the firm's balance sheet unchanged.

Or would we? Under current market conditions, "selling" the life insurance policy liability to another firm might be possible, but it would be highly unlikely to have the same gain as the Treasury position.

That example is very black and white, and of course, the real world is much more grey. Its easy to use a Treasury bond as an example, where we know the change in market value isn't reflective of a change in asset quality. But where there has been a real change in asset quality, the situation becomes more grey.

But still, mark-to-market still doesn't fully satisfy. Let's say that we have two firms, both have made loans to XYZ Retailer. But one is a bank which has made a traditional loan, and the other is a brokerage which holds a private placement bond. The broker almost certainly has to mark that loan to market, but the bank may not.

And in both cases, the rapid changing liquidity premium in the market place alters the "mark" for this asset. By this I mean, say the retailer is performing reasonably well, and thus the risk of non-payment remains remote. Given the weak economy, its obvious that the risk has increased by some degree, but given the extremely weak liquidity across fixed income products, the larger portion of the assets price decline would reflect liquidity. If the firms don't intend to trade the loan, is the changing liquidity premium relevant?

There are other problems. Say you are a bank that has a private loan to a company with traded CDS contracts. Your best mark-to-market estimate would be to price the loan based on the cost of hedging out the credit risk. But in many cases, the CDS and cash bond markets have decoupled. Many bonds are trading a drastically wider levels than the CDS market, owing in part to easier funding of CDS. Take Amgen, where cash bonds are trading at a LIBOR spread of nearly 300bps, but the CDS are around 90bps. On a 10-year loan, that implies a valuation differential of about 15 points!

So here again, we have a situation where two firms can use "market" prices to price non-marketable assets, and come up with wildly different valuations. We hear mark-to-market and assume that the "market" is some kind of observable thing. But that is just not the case.

I argue that when the current fair value accounting standards were cooked up, a rapid change in liquidity premia was never envisioned. It was assumed that the market would deliver an efficient price which was primarily reflective of the real economic risks of a security. Thus a change in price would reflect a change in risks. It makes perfect sense in theory, but clearly does not reflect economic reality for some firms, nor does is it creating balance sheets which are comparable across firms.

But what's the alternative? Those that are calling for an end to mark-to-market are out of their mind. First of all, there is no clear alternative. Second, we have enough trouble trusting firms' balance sheets as it is. Imagine if mark-to-market were suddenly suspended!

And it doesn't help that so many critics of mark-to-market in the recent past have been managers of firms who were, in fact, fudging the real economic position of their firm.

So I don't know what the answer is. And I don't blame accounting for the financial crisis that we're going through. But I'd like to see some better ideas.

23 comments:

I think you summarized the debate well. It always pisses me off to hear the hubris of the extreme advocates of one side or the other.

I'm hoping that two things happen more and more in the long run:

1. More movement to exchange trading when possible.2. More disintermediation. I think that a lot of the risks in fractional reserve lending can only be removed by having more direct loans from consumer to real resultant lender. ie, CP. While it may have been painful for companies to pay up to issue cp, at least any defaults would have directly hit the holders and not have instead ruined banks.

I'd also like to voice my opinion that I concur with almost all of your piece. What annoys me particularly are two things that you point out. One, the irrational one-side-or-the-other debate. I find that when I discuss m2m with people (I'm an accounting graduate student), people who voice an opinion to one extreme or the other tend to have a very poor understanding of the actual mark to market rules to begin with. The second thing, which ties into the back end of the first, is your point about alternatives. I almost always find myself ending any discussion with that question, and the lack of any answer usually goes a long way to show people's lack of understanding of the issue.

A derivative shop needs to account for everything like derivatives. Mtm and fas 133 are designed for them - no arguments. Real economy businesses are more complex.

We could take a common stock and deconstruct it into a put, a call, and cash and account for it as derivatives. However, we could also just treat it like a stock and if it is part of a held portfolio, let the changes flow through other comprehensive income - which hits the balance sheet but not the income statement. The periodic gains and losses show up as unrealized capital gains and losses. In this obviously rhetorical example, the only difference is the various lines the figure appear on in published financial statements. Still, if a firm holds stocks for investments, it does make sense to book them on the balance sheet at their market value, but not confuse core income with short term fluctuations. People do a LOT with GAAP net income figures. The stocks aren't "marked to market" even though they are booked at market value, since you aren't using fas 133. And the unrealized changes go through a line in other comprehensive income instead of net income.

Anyway, mark to market isn't always conservative.

I did a blog post recently on booking liabilities using mark to market. Most people don't believe it.

http://capitalvandalism.blogspot.com/2008/12/mark-to-market.html

On a more general note, the idea that markets are deep, liquid, and efficient and that we should believe that accounting for derivatives is the best approach to accounting for everything strikes me as a fundamental error.

Per my earlier post, I was unclear, but meant that unrealized capital gains go through other comprehensive income and when they are realized (or impaired), they go through net income.

Anyway, your first point where an insurance contract is totally hedged, then there may already be accounting rules that recognize a perfect hedge and would allow netting. However, more likely, there isn't a perfect hedge but rather partial hedges with non dedicated portfolios.

More important, you have non functioning markets and an accounting rule that prefers a market doesn't create a bona fide market. People can rant all they want, but the desire for a market doesn't create one. An attempt at 'price discovery' under duress will lead to no good, since it is pro cyclical and would tend to increase the amplitude of cycles.

Finally, in real businesses, the most valuable assets are the least marketable. Intellectual property. Brands, The list goes on and on. GM can't buy and sell factories on an exchange.

GAAP is based on the going concern concept and liquidation accounting isn't very useful for non financial firms.

Vandal I think I agree with what you are saying but I am unsure. What does GM's factory valuation have to do with fv accounting practices? Are people suggesting that they should carry their P&E at fair value (whatever the hell that is in that case)? If so, I am glad I have not run into that crowd. As far as the idea of liquidation accounting for non-financial firms, do you then think that inventories should not be marked to LCM?

I don't know any rational person that would propose that P&E be marked at fair value -- whatever that would mean -- but I have read plenty of rants that use overly broad language that would amount to the same thing. For example, a loan on a non financial asset that is inherently illiquid moves you in this direction.

I agree. It's not black and white. This problem exists in most accounting rules. In the end it should all equal out the same. I think in many cases this has created some real investment opportunities for the enterprising investor. A straightforward example is MBIA. Accounting rules require revenue recognition for premiums to be recognized over the term of the policy. MBIA collects the entire premium up front and has the cash on hand. The investor has to adjust book value. On another note- Josh Kalish, is this the same Josh who was my classmate and partner at Columbia. This is Alex

Standardization of contracts in the derivatives market could defuse much of this debate. It would lower the cost to investors who rely on bespoke contracts while at the same time reducing liquidity premia. In fact, now is the time to demand such reforms, with the weakened position of the majors. If we had such trifling things as uniform coupons on CDS contracts, the system would be able to delever much less painfully.

I agree with the sentiment of the post, but there are definitely issues with the ways accounting has been used by companies and banks to show profits and hide losses. It really seems to depend on what the term of the liabilities are relative to the assets held. If the liabilities are short term, or coming due soon then it seems that the assets should be marked to market. If the liabilities are much longer term then some balance could be struck between the purchase/expected/market pricing.

One point though is that even market pricing doesn't correspond to liquidation pricing... no that would be much worse since these are banks and the size of their illiquid holdings would by definition move the market- Down. Mark to market would be kind pricing, if substantial things actually had to be liquidated today.

I wouldn't even mind a balance of long/short term assets/liability marking during this crisis, but that doesn't seem to be happening either. Instead we have SIVs, QIVs, off-ballance-sheet, and un-callable Fed loans extended into oblivion for long term loans funded with short term debt. Everyone knew this was risky by definition, that's why there was margin to be made.

Accounting seems to have a bit too much to do with the indecipherable intent for the assets held, rather than just forcing assets and liabilities terms to be matched or provide higher collateral/margins. When this becomes a game of 'just trust us', don't be surprised when people don't.

Management wanted to show short term profits on long term deals so they could make the big bonuses. The pushed the little guys downstairs to do the same thing so they bought and sold crap and ultimately there was no responsibility.

Why wasn't someone like a ratings agency looking at the risk this posed and forcing them to hold reserves to cover the risk? Why were they ever using 10-15 year statistics to make AAA ratings? That's just obvious BS no matter how you paper it over with math.

Great post. I know by firsthand experience the issue of liquidity risk premium between loans and CDSs, since I was one of the first in the market to live through the associated internal transfer pricing issues (between originators and the risk book) at BT in the early 1990s. I do agree that there are shades of grey in the debate and that it is not a black-or-white issue. To me, one of the fundamental questions surrounding the liquidity risk premium is how pressing the "liquidation" aspect is. The more a company is close to the edge, the more urgent a liquidation of its portfolio, regardless of fundamental value considerations. Excluding such an extreme instance, the definition of an accounting reserve policy is a way - not perfect, of course, but still far better than marking everything at face value and hiding your head in the sand - to address the problem. In your loan-versus-CDS example, one could, for instance, mark the loan based on its fair value (for instance vs comparable loans) and reserve the difference in price between the loan and its CDS-implied value. Over time, the reserves could then be released. The advantage of this mechanism is that a "war chest" to hedge the loan in the CDS market later on remains in the balance sheet of the institution. The disadvantage - from many managers'point of view - is that it will mean lower short-term earnings and, most important, bonuses. In the current "institutionalised recklessness" environment, that seems a reasonable price to pay.

post is good and debate here in the comments is interesting. why is it that those who are long the derivatives feel as though they should get special treatment with regards to the a/c rules? personally, i've NO vested interest either way as an independent fixed income strategist here. the regulators who 'cooked' up the rule possibly didn't have derivatives to govern. those who invented derivatives more than likely knew of these sorts of risks but chose not to pay any mind to them as the mkt was going in the 'right way'. assuming that this certain type of asset class shouldn't be governed by fas 157, 133 or the new 140 (?) as it wouldn't ever need to be sold is simply ridiculous. why of all the assets on a bank or bookies balance sheet would this of all assets be the shining star that would never have to be sold? how can any of us sit here and suggest that and therefore, these shouldn't be counted or marked? I’m realistic and know that my sh!t st!nks. move on.

at the end of the day, your post leaves off in search of more and better answers. the next couple of years of deleveraging - financials have begun the process and the general economy is going to carry on - will provide us all some answers. the rocket scientists who 'cooked' up the product (not the rules) and created the market for this toxic stuff will find they too will be marked to market and thrown under the bus. This stuff gets to an exchange, has a ‘+’ spread and everyone will know who’s swimming without trunks. That will help a bunch, no?

Re your Treasury Strip analogy - donno. That entirely misses the point IMHO as the last few years have seen that sort of account NOT buy Treasury stuff, but stocks, and allocate money towards other (alternative) areas, as they were the only game in town. Folks who shouldn’t oughtta been involved in commodities, hedge funds, timber, real estate and oh yea, STOCKs, were and were, in a BIG WAY. Case in point – CalPERS having to name a new CEO. Folks abandoned ALM (asset liability management) and, well, common sense. At this point in the cycle of rates, there are STILL relatively FEW longs in Treasuries – yesterday’s JPM Client Survey is a perfect example – longs were 14, neutrals 70 and shorts were 16. One could only WISH they bot those strips as soon as available. THAT wasn’t the problem and I realize you were trying to make a point. Suppose MY point is that an insurance company buying a Treasury Strips to offset a liability is NOT in the news at the moment and shouldn’t be. They can freely market 2 market and not worry about consequences of derivatives as they were doing their fiduciary duty It’s the other guys doing more funky stuff that might be up here reading your post about m2m that is more the concern. There aren’t any free lunches.

Keep up good work here on blog and hopefully this year has been OK to one and all ‘out there’ involved in these crazy markets …

As a retired manufacturing owner sitting on the sideline its my take that M2M is critical if the financial sector wants investment dollars. Confidence in the financial process leads to better investment flows and without M2M that confidence would be impossible.

Lots of good points in the post and comments. One additional: mark-to-market rules are not absolute and they contain a specific set of notes that as assets become illiquid it's understood that value cannot be assigned. In other words, the hue & cry about how mark-to-market destroys balance sheets ignores the rules themselves which say that you don't mark instruments to salvage value as the market locks up. Much of the discussion generally is an attempt to deflect blame by financial companies who mismanaged risk while chasing short dollars.

All accounting rules have issues but absolutely nothing can be gained for market function if we obfuscate. In plain English, we hear over & over & over that counter-party confidence is one of the absolute main issues and suspending mark-to-market (or materially weakening it) would only reduce counter-party confidence. Who could you then trust?

Every institution engaged in economic activity in the world, be they private or public, small or large, for profit or non-profit, commercial or governmental, uses mark to model to pay its own employees.

The very journalists criticizing mark to model are paid on mark to model accounting every single week.

My company submits bills for services performed, we 'model' a collection on those bills, payroll is paid and 6 months later we reconcile collections with the 'hope' we will turn a profit. There is no other way to run a business.

I know of no system that can ever be designed to be independent of the integrity of the individuals who make up that system- EVER.

It may be a little cliche but it unfortunately seems to always hold true- a chain is only as strong as its weakest link. Oversight does not change this fact one bit.

I am curious what you think about the impact of the Madoff story will have on Mark-to-market. Will the Feds bow to corporate interests to suspend mark to market or will they lean towards greater transparency to avoid the kinds of mistakes that led to regulatory myopia?

I believe in m2m, but we dropped a business line this year because the way we had to implement m2m put us at a disadvantage to our competitors. The implementation was the problem for us, not the goal or the resulting values. If five firms carry the same asset and yours is always lowest its not good for business. I suspect some of the extremism on m2m may relate to issues of this nature.

I agree with your post. Sadly, as a layperson, I don't see a simple solution either. The (justifiable) appeal of mark to market is that it is simple and provides an external reference point to judge the value of something. This is a reassuring option when you feel that companies have been playing fast and loose with the figures. I don't think m2m would even be an issue except that illiquid instruments seem to have played a very big part of the current problem and the speed and depth of the unraveling of markets has stunned a lot of people. I can't say anything except that perhaps big swings in the value of illiquid instruments is the price that companies have to pay for using them. I don't see another way around, except ones that are open to all sorts of arbitrary, 'funny money' valuations that are made by the companies that have a vested interest in keeping those values high. :/

I confess that many of the arguments are above my head, however it seems to me that everybody is forgetting one essential point: the banks bought these "assets" on margin, ie with money they do not have. Once the value of these assets plunges the bank is insolvent. Had the banks bought the assets with money whether they had M2M or any other rule would matter much less. is tis clear or am I crazy?

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.